Reo Notes - Mas
Reo Notes - Mas
Reo Notes - Mas
MAS Defined
− Management advisory services refer to the function of providing professional advisory
(consulting) services, the primary purpose of which is to improve the client's use of its
capabilities and resources to achieve the objectives of the organization.
2. Graphic Approach
Total Revenues and Total Cost are presented in a graph where Y axis is in Pesos and
X axis in units. The point wherein the TR and TC will intersect is the Break-Even
Point. The graph is called Cost Volume Profit graph. The most important information
derived in a CVP graph is the relationship of revenues and costs at different levels of
quantity. This is very helpful in profitability analysis.
3. Contribution Margin Method or Formula Approach
This approach utilized the concept that the contribution margin at BEP is equal to the
Total Fixed Cost. Please refer to the formula section of this module for a complete list
of the equations.
IV. Margin of Safety
Indicates the amount by which actual or planned sales may be reduced without
incurring a loss. It is the difference between actual or planned sales volume and break-
even sales. It is the profit area in the CVP graph. It should be noted that profits are
generated only within this range. It is computed by deducting BEP Sales from Total
Sales. Please refer to the formula section of this module for a complete list of
equations.
V. Factors Affecting Profit
Profit will change as long as any of the factors needed to compute for total revenues
or total cost will change. Most of the time this is used to determine the best course of
action by changing variables and looking at the possible effects. It is important to note
that any peso change in contribution margin will have the same peso effect on profit.
The factors are:
1. Selling Price per Unit — a change in selling price will affect total sales, total
contribution margin, and profit.
2. Variable Cost per Unit — a change in variable cost will affect total variable cost,
total contribution margin, and profit.
3. Volume or Number of Units — will affect total sales, total variable cost, total
contribution margin, and profit.
4. Fixed Cost — changes in fixed cost will affect total cost, and profit; and
5. Sales Mix — refers to the combination of products if a company sells more that
one product. Changes in sales mix will affect the composite
contribution margin resulting to changes in total contribution margin
and profit. Composite contribution margin refers to the weighted
average contribution margin of a group of products.
NOTE:
− The factors presented in the previous paragraph will affect profit. But all factors except
sales units will NOT affect BEP. Because the BEP is constant in the relevant range
regardless of sales units.
− In addition, change in income tax rates will not affect BEP, because there is no income
subject to tax at BEP.
VI. Degree of Operating Leverage (DOL)
It is a measure of how sensitive net operating income is to a given percentage change
in sales.
Let's say if a company has DOL of 4x and Sales will increase by 20%, it is expected
that Profit will increase by 80%. DOL is limited by the assumption that the increase in
sales is attributed to the increase in Sales units and not on Selling Price. It is computed
as:
DOL = Total Contribution Margin / Operating Profit
DOL = Percentage Change in Profit / Percentage Change in Sales
VII. Formulas In BEP Computation
The following equations can be used depending on the given data.
1. BEP Pesos
=Total Fixed Costs / Contribution Margin Ratio
= Total Sales Pesos - MOS Pesos
2. BEP Units
= Fixed Costs / Contribution Margin per Unit
=Total Sales Units - MOS units
5. Fixed Cost
= Total Contribution Margin – Profit
= Total Cost - Total Variable Cost
= BEP Units x CMU
= BEP Pesos x CMR
10. Profit
= Total Revenues - Total Cost
= Total Contribution Margin - Fixed Cost
= MSU x CMU
= MSP x CMR
= Total Revenues x NPR
CMR
= BEP Pesos + MOS Pesos
13. Total Sales Units or Number of Units To Be Sold To Earn A Desired Profit
= Total Fixed Costs + Desired Profit before Tax / CMU
= Total Fixed Cost + Desired Profit after Tax
(1 – Tax Rate)
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CMU
= BEP Units + MOS Units
*Mix Ratio — is determined by dividing the Total Sales Units or pesos of a Single Product
by the Total Sales Units or Pesos of All Products Combined.
CAPITAL BUDGETING
I. Overview
Capital Budgeting — the process of identifying, evaluating, planning, and financing capital
investment projects of an organization. It is the process of evaluating the
acceptability of potential investment alternatives. It Involves the ranking of
investment alternatives if a company is faced with a capital rationing problem.
The process intends to help the financial manager choose the best project
with the best return for a given period of time.
Characteristics of Capital Investment Decisions
1. It Usually Requires Large Commitments of Resources
The amount of required investment is significant enough that it qualifies as a capitalizable
expense or carried as an asset of the investing company.
2. It Involves Long-term Commitments
The investment is able to provide immediate and long-term benefits to the investor.
3. It is More Difficult to Reverse than Short-Term Decisions
Investment in non-current assets are not easily disposed off if the decision maker made
the wrong choice. Immediate disposal will required great efforts and possible material
losses.
The Capital Budgeting Process
1. Identification of Potential Projects
This involves looking for possible investment projects that will satisfy the objective of the
company. The proper method of evaluating investment alternatives is highly dependent
on the desired objective. The decision may involve, independent projects, mutually
exclusive projects, or capital rationing. This will be discussed later in detail.
2. Estimation of Costs and Benefits
Estimating the costs involves measuring the net investment. Net investment is the
required net cash outflow at the date of inception of the project. Please refer to the full
discussion of net investment. The net benefits pertain to the accounting net income and
cash inflows after tax. Net income is intended to measure profitability, while cash inflows
after tax is intended to measure project liquidity. Please refer to the net returns for full
discussion.
3. Evaluation
This phase involves determining the profitability or liquidity of the project proposals. The
decision maker has the option of using discounted or non-discounted techniques or both
in evaluating projects. Please refer to the tools in evaluating investment alternatives for
full discussion.
4. Development of the Capital Budget
This phase involves the actual implementation of plans.
5. Re-evaluation/ Post-audit
This phase determines if the desired objectives were attained. At this point it is advised
that the decision maker should use actual data in evaluating attainment of objectives.
Information gathered from Post-audit is useful in improving the capital budgeting
process of a company.
Economic Life — is the period of time during which the asset can provide economic benefits
or positive cash inflows.
B. Accounting net income or Earnings Before Interest but After Tax (EBIAT)
This measures the profitability of an investment project. Interest is ignored
because evaluating capital budgeting projects involves an analysis if the project's
profits can recover financing cost needed to fund the project.
It is typically computed as:
Sales xxx
Less: Cost of Sales (xxx)
Gross Profit xxx
Less: Operating Expenses (xxx)
EBIT / Operating Income xxx
Less: Tax (xxx)
EBIAT xxx
C. Cost of Capital
Represents the overall cost of financing to the firm of the Weighted Average Cost
of Capital (WACC). It is also known as Hurdle Rate, Target Rate, Minimum
Acceptable Rate, and Minimum ROI. The cost of capital is the average return that
the company must pay to its long-term creditors and its shareholders. It is the
discount rate used in evaluating capital investment decisions. For purposes of
Capital Budgeting, it is assumed that the WACC is already provided. WACC is
fully discussed in the category "LONG-TERM FINANCING".
D. Time Value of Money
The Time Value of Money (TVM) is the concept that money you have now is
worth more than the identical sum in the future due to its potential earning
capacity. This core principle of finance holds that provided money can earn
interest, any amount of money is worth more the sooner it is received. Therefore,
projects that promise earlier returns are preferable to those that promise later
returns. The capital budgeting techniques that best recognize the time value of
money are those that involve discounted cash flows. Effects of time value of
money will be presented under the sub-topic "Discounted Techniques."
E. Income Tax
The income tax usually has a significant effect on the cash flow of a company
and should be taken into account while making capital budgeting decisions. An
investment that looks desirable without considering income tax may become
unacceptable after considering income tax. The three concepts of income tax are
After-tax Benefit, After-tax Cost, and Depreciation Tax Shield.
1. After-Tax Benefit or Cash Inflow
These are the tax imposed on Taxable revenues or cash inflows. When
reduced by the income tax, it is known as after-tax benefit or after-tax cash
inflow. When income tax is considered capital budgeting decisions, after-tax
cash inflow is used. An example of taxable cash inflow is cash generated by
a company from its operations.
2. After-Tax Cost
These are expenses or costs that can be deducted against revenues for
purposes of computing income tax. Tax deductible costs reduce taxable
income and help save income tax. A cost net of its tax effect is known as
after-tax cost.
It is computed as:
After-Tax Cost = (1 — Tax rate) x Tax Deductible Cash Expenses
3. Depreciation Tax Shield (DTS)
Depreciation is a non-cash tax deductible expense that saves income tax
by reducing taxable income. The amount of tax that is saved by depreciation
is known as depreciation tax shield.
It is computed as:
Depreciation Tax Shield = Tax Rate x Depreciation Expense
III. Non-Discounted Technique
These are capital budgeting techniques that do not consider the time value of money.
1. Payback Period
2. Accounting Rate of Return
A. Payback Period
It is the length of time required by the project to recover the initial cost of investment. It
is a test of a project's liquidity. A project is acceptable provided that the payback period
is less than a company's acceptable payback period. The lower the payback period the
better.
A major advantage of payback period is it is easy to compute. The payback method can
serve as a screening tool to help identify which investment proposals are acceptable
based on company policy. It can help companies that compete in industries where
products become obsolete rapidly to identify products that will recoup their initial
investment quickly.
Payback period has its own limitations. It does not consider the time value of money. It
ignores cash flows after the payback period, thus it has no inherent mechanism for
highlighting differences in useful life between investments. And it tends to be misleading
because a shorter payback period does not always mean that one investment is more
desirable than another.
The formula to compute payback depends on the behavior of CIAT.
Even CIAT = Initial investment / Annual Net Cash Inflows
Uneven CIAT = When the cash flows associated with an investment project change from
year to year, the unrecovered investment must be tracked year by year.
Cash inflows in each specific year starting with year 1 is deducted against
the Initial Investment until fully recouped. A full year's cash inflow is
considered as 1 year and a faction is prorated during that year.
B. Accounting Rate of Return — AROR (also called Book Value Rate of Return, Financial
Statement Method, Average Return on Investment, Simple Rate of Return, and Unadjusted
Rate of Return) is a test of projects profitability. It determines if net income is sufficient to
settle financing cost associated with the project.
A project is acceptable if AROR is equal or greater than WACC. If AROR is equal to WACC,
it signifies that net income is just enough to settle financing cost. It is better if AROR is greater
than WACC, it signifies that the project can recover financing cost and can generate profits.
It is computed as:
Accounting Rate of Return
AROR on Initial Investment = Average Annual Net Income / Investment
AROR on Average Investment = Average Annual Net Income
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